Australia's bull trap

David Llewellyn-Smith

Financial repression is a phrase used to describe a set of policies that reduce the real interest rate to zero or below. These are enacted by governments or regulators aiming to mitigate a debt burden in either the public or the private sector.

The low interest rate has the combined effect of lowering debt issuance and servicing costs, as well as increasing bank margins. The knock-on effect of currency debasement boosts competitiveness, investment and inflation. All of these assist in rendering the debt-stock in question more manageable and, ultimately, shrinking it in real terms.

Readers will recognise that these conditions already exist in most advanced economies as private sectors in the United States, Europe and Japan are at various stages of unwinding debt bubbles of the past few decades. The technicals vary but the tools are the same.

Japan remains a contained mercantilist state, fighting its demographic headwinds and formerly corporate debt bubble via endless deficit spending of its government, which borrows from its people at extraordinarily low rates guaranteed by repeated quantitative easing measures conducted through its central bank.

The United States is a more open economy and is making more swift progress than Japan did in its deleveraging, but its household and corporate debt loads are still miles above historical norms. Its government also continues to deficit spend at rates in excess of sustainability, assisted in its endeavour by fabulously low interest rates across the curve, in part held in place by quantitative easing by its central bank.

Like Japan, this has stabilised its financial system and some renewed borrowing is apparent as household formation picks up. This will continue but with each successive year get more difficult. Growth from a low base has proved hard. Growth from each higher base will be tougher still. Owing to more favourable demographics and a more dynamic economy in general, US financial repression is unlikely to last as long as that of Japan. But if it takes half the time, the period from the GFC until now is about one-third of what will be required. Meanwhile, the US will export its weakness wherever it can.

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Europe is harder largely because it barely exists beyond its putative bureaucratic dream. The disparate group of states with a shared interest rate and currency, but little else, uses a combination of super-low interest rates, fiscal engineering and constraint, as well as wage deflation to resolve its various debt bubbles. It's approach has merit in the text book and in the capitalist ledger but its refusal to support the process with shared debt burdens constantly threaten political mayhem. Europe may win in the end but only if it can prevent civil war.

And it does not stop there. The same conditions of financial repression permeate much of the emerging market world as well. The matrix is different but the tools the same. In China, interest rates are also held at low levels relative to growth and inflation to boost bank margins in the face of mounting bad loans derived from years of overspending on uneconomic infrastructure to meet official growth targets.

The underlying dynamism of the economy is real and its prospects for large productivity gains very large in the long term. But the rise to influence of companies and individuals that have a vested interest in sustaining the unsustainable means financial repression goes on. Capital controls ensure the currency is fixed and that domestic liquidity is ubiquitous. The unwind will be long and each subsequent year will face the same question as the last, more pressing each time. How much will the communists renew spending on bridges to nowhere?

The shift is real

Which brings us to Australia. So far, it has been different Downunder. Despite a huge household debt load, Australians have not faced a deleveraging cycle. We have to date disleveraged, reducing our borrowing growth rates not reversing them. This is has been made possible by a once in a century mining boom which boosted incomes, jobs and the simple velocity of money in the economy, easing the generational shift away from debt-accumulation which is part and parcel with financial repressions.

But the shift is nonetheless real. The mining boom and disleveraging have prevented a rout but despite epic dimensions could still not disguise lacklustre growth in most of the economy. 2011/12 were the years of official forecasting misfortune. Thus the central bank and the Treasury both missed the mark in expecting China and the mining boom to outweigh the malaise in the debt-fuelled service sectors, though thankfully their integrity prevailed and action contradicted predictions. 175 basis points of interest rate cuts over 15 months and the endlessly deferred fiscal surpluses tell us that.

But the Australian interest rate structure is still high; too high for the rough beast that is approaching the economy. Around mid-year the peak in mining investment growth will arrive. As we've been told very often, this peak will be high, very high, though not nearly as giddy as assumed by our optimistic authorities. Nonetheless, the height of the peak is about to become a problem. A steep peak means an equally steep descent.

What this means, of course, is that our special moment is passing. As the mining boom fades, so too is the support for disleveraging. Something else will have to take its place.

In my view, the first half of the year will be OK. We may see another interest rate cut in the next few months in an effort to bridge the approaching growth gap. However, the timing of further rate cuts has been complicated by the China and iron ore price rebound which will boost national income and nominal growth in the first half. Of course this is good but comes with an attached risk. China is NOT embarking on a new cycle of renewed investment vigour. Rather, it is staving off its own inevitable descent from unsustainable investment highs.

The communists have decreed that the decline will be a managed slope but it will still happen. The second half of 2013 is not going to bring acceleration in a new Chinese cycle. It is going to look more or less like the second half of 2012, with Chinese growth and bulk commodity prices under pressure. Iron ore will fall on subdued Chinese demand and awesome new supply. Coking coal is better placed long-term but also has awesome new supply. Thermal coal will fall on declining demand and awesome new supply. LNG does not kick in earnest until 2014/15.

Expect the China-will-save-us bulls to upgrade forecasts in the next six months but they are straddling a bull trap which looms at the feet of Australian authorities. In my view, this last hoorah for iron iron ore will slightly ease precipitous investment decline ahead but that's is all. Higher prices at this stage will translate mainly to boosted mining profits (80 per cent of which go offshore) and higher government revenues. Neither increase private sector economic activity beyond perhaps some small wealth effect from a decent stock market run.

The danger is that this combination of variables delays further monetary policy easing. There is bugger-all momentum in the housing economy (excepting apartments and Perth); there is bugger-all momentum in the services economy more broadly, there is bugger-all momentum in non-mining tradeable goods, manufacturing, construction, government, you name it. If the RBA delays more easing then the dollar will rally.

Allowing this to happen as we approach our own investment cliff would not be a good idea. The dollar must fall and it most certainly will, but the longer it is left to do so alone, the weaker the rebound will be afterwards. I am talking about being hollowed out.

Election looms

There is one more feature of the year ahead that we must consider. The Federal election approaches in October/November. Polls look fairly even at this stage with Tony Abbott by a nose. With Labor having abandoned its surplus pledge (but perhaps being gifted a long-shot second chance by iron ore) government spending can and will support the economy. At least there will be less cuts. Across the aisle, however, looms another danger. The Coalition appears totally locked into its surplus mindset. I don't know if this is some halcyon-days view of the Howard years, pure Austrian ideology or just Opposition politics. Hopefully the latter. Next year already looms as a real recession possibility. If the Coalition comes to power and immediately cuts spending, difficult will become bad.

The same risks await the average punter. The lower interest rates that are coming should not be thought of in historic terms as either the “bottom of the cycle” or “emergency” settings, at least, not in any immediate sense. They are not even responding to an emergency any more. It's the new normal, now just normal, in which the free flow of global capital is being sensibly crimped to stabilise global banking systems. A modicum of de-globalisation as it were. In this environment, current account deficits matter.

We've staved it off with government spending and guarantees to our banks, as well as a serendipitous mining boom. But the underlying fact will remain. Australian households have too much debt. The level must fall relative to the surrounding economy. Financial repression is the way it will do so. That is a structural shift, not cyclical.

What does that mean to you? It means that despite favourable tax treatment, solid immigration and an unbowed politico-housing complex, house prices will again disappoint. The much-touted housing “recovery” is a dated term that has limited reference in today's world of ongoing structural adjustment. When current account deficits matter, house prices rise or fall in response to the broader economy, they no longer drive it because the debt is not available. At a national level, flat in real terms is my guess, with risks to the downside mitigated by property investors' “search for yield”, the flipside of financial repression. Moreover, in the longer term, the risks remain to the downside as the mining boom and demographic dividend passes and because of Australia's lack of competitiveness in anything else.

Shares should do better. Though valuations are already remarkably stretched, earnings growth will be decent for the miners for the first half and the hope that a soft landing can be engineered by authorities has already lifted markets. More to the point, financial repression boosts financial assets as official interest rates fall and risk premia contract. Nonetheless, those seeking to buy and hold shares on anything other than the very longest of time-frames should be aware that they are in some way buying a fiction. Folks will periodically wake up. I continue to favour dollar-exposed industrials. They are our most globally efficient firms and will grow at least in line with the wider market, if not more so. More to the point, when the dollar corrects with falling interest rates the falls will result from weakness in everything else. It's a natural hedge.

Fixed interest investors can expect yields on term deposits to fall further but the pressure on bank funding remains and the good news is that much of the financial repression spread that will be gifted to our financial firms will be on the asset side.

There is no prospect of a reversal for interest rates as far as my eye can see: inflation is quiescent, the trend in wages growth will continue to ease as national income falls after a bump upwards in the first half. Eventually the dollar will fall substantially but not until economic weakness demands it and that will cap inflation anyway. Productivity will also continue its rebound.

On the fiscal side, as MacroBusiness has argued for three years, the surplus is and should be history. Anyone voting on that basis later this year needs to update their frame of reference. Although surplus politics will no doubt define the Coalition side of the campaign, make no mistake, it does not matter who is now in power, the Australian government will either borrow or the economy will weaken. While it might be argued that some of the weakness is welcome, cleansing past mal-investment, we've had years of pressure on our non-mining sectors already, coping with a real exchange rate at its current levels has been the greatest of disciplines. I hope that the Coalition, should it win office, will not have to learn the hard way that when wrestling with a debt-stock of the magnitude held by our households, economic weakness can spin out of control.

All across the world, major economies are converging on the same spot, some from the point of high private debt, some from the point of high public debt, some from the point of free markets and some from the point of central planning. All are using various configurations of financial repression to grow beyond the constraints of the national debts accumulated over of the past three decades of easy demographic dividends, Keynesianism and globalising finance. Now instead they are doing everything they can to seize the largest possible share of the globe's limited investment capital.

In a sense, this is an era of truer capitalism to that which preceded it. You compete or you die.

David Llewellyn-Smith is the editor of MacroBusiness, where this article was first published.